Once the credit bubble popped, many investors, myself included, turned their back on financial stocks. Hardly surprising, given the scale of the subprime lending fiasco and subsequent concerns about solvency. Yet the industry shouldn’t be totally written off. There are some bargains around, particularly among firms with solid balance sheets and substantial overseas interests. Even legendary long-term investor Warren Buffett has recently taken stakes in Goldman Sachs and Swiss Re.
ICAP (LSE:IAP), rated a BUY by Bank of America
A great example is ICAP. The share price has fallen a whopping 65% over the past 12 months, despite profits rising every year since 2004. What’s more, ICAP benefits from current turbulence. As the world’s largest ‘inter-dealer broker’, it makes money by charging commission when it buys and sells financial products (interest-rate swaps, commodities and fixed-income securities, for example) in privately arranged deals on behalf of institutional clients. So the recent period of volatility saw ICAP’s results boosted by high trading volumes (sometimes over $1trn per day). Importantly, ICAP doesn’t own the assets in which it arranges deals, but simply transfers them between parties. This enabled the firm, for example, to avoid taking any direct hits from the collapse of Lehman Brothers.
But why has the stock tanked, given it is effectively a counter-cyclical play on the credit crunch? First off, due to the recent meltdown, law-makers all around the world are discussing measures to regulate the sort of activities ICAP is involved in and improve market transparency. One temporary measure was to ban speculators from short-selling banks, which led to a tail-off in ICAP’s November volumes. Regulation may eventually drive some, or all, of the firm’s bread-and-butter business onto regulated exchanges. This is a potential threat to ICAP, which may have to convert into a quasi-exchange and invest time and money to meet the relevant rules. Another option would be for ICAP to buy an exchange. Chief executive Michael Spencer is already considering buying LCH.Clearnet as part of a larger consortium.
After something of a purple patch, the City is worried that as its clients (banks and hedge funds, for instance) retrench, trading volumes may tail off. But there’s little sign of that yet. Revenues grew 20% in the final three months of 2008 and the board is predicting “increased activity in highly traded assets” where the firm is strong. This will be offset by “reduced demand for structured products (such as derivatives)”. This shift will compress profit margins, but that should be more than compensated for by market-share gains as customers migrate to the biggest blue-chip brokers – such as ICAP. Furthermore, Spencer is planning cost-saving measures, including job cuts and pushing more deals through its electronic platforms, a cheaper option than agreeing them over the phone.
The City is forecasting turnover and underlying earnings per share (EPS) of £1.5bn and 33.5p respectively for the year ending March 2009, along with a 17.5p dividend. As such, the stock trades on a frugal 6.8 times earnings and pays a generous 7.7% yield. The dividend is covered almost twice by earnings and is supported by a solid balance sheet with net debt (debt less cash) of £243m. Yes, there are risks, but overall, with the firm supported by sterling’s weakness, the stock represents good value for the more adventurous investor.
Recommendation: BUY at 226.5p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments.